May 12, 2014

Help a Reader: Retirement Tipping Point

Here's an email I recently received from a reader:

I have a question to which I haven't been able to find an answer online. I'm currently 32, have about $25,000 in my retirement accounts, and contribute approximately 18 percent of my income to my employer-sponsored plan and Roth IRA. I'm wondering when, if ever, I can stop contributing to these plans. I've read articles to the effect that people who invest for 10-15 years early in their careers (and then stop) do just as good, if not better, with final balances as those who start at 35 or 40 and contribute for the remainder of their careers.

I'm just curious... what is that "tipping point" where my contributions aren't going to make a significant increase to my final retirement balance. Is there a way to easily calculate this or is this a better question for a financial planner?

Comments

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It's quite easy to project, even using a tool as blunt as an Excel spreadsheet, how much money you will have in a retirement account at the end of 15 years, given your current contribution rate, making whatever assumptions about the state of our economy in the intervening years make sense to you. But they're all just assumptions, and you never know whether your rate of return will match your assumptions, so it's all just a best guess, anyway.

You can then make similar assumptions about how much you anticipate spending in retirement based on your desired lifestyle, to see if the money will last. Again, the tool doesn't matter, and all the mutual fund companies and banks out there who offer retirement plans have calculators available to make those types of projections, as well.

If you come to a point where you have several million dollars in IRAs or 401Ks or.... then the next thing to think about would be diversifying your retirement income stream by investing in rental real estate or buying a business that generates additional cash flow.

Just my opinion. If you've learned to live on your income, minus the 18%, re-direct the 18% instead of simply ceasing to invest it in tax-advantaged retirement funds.

My current plan is to invest in retirement accounts until I am about halfway to my goal and then start switching some investing to non retirement accounts. Retirement accounts penalize you for withdrawing early and if you plan on retiring early you will need some money somewhere else.

But those who start early and contribute there percentage until they fully retire do the best.

The tipping point is just for illustration. 10K per year saved for 15 years at 6% is $233K. $233K earning 6% for the next 20 will be $750K. Will that be enough for what you think you want? (I use 6% to equate 9% market - 3% inflation on average to put it closer to today's dollars IMHO).

$10K per year for 20 years at 6% is $368K, is that enough if you wait until you're 40 to start saving?

However, 10K per year for 35 years @ 6% is $1.12M, does that sound better?

I don't see a "tipping point". I see people needing to know their goals, in other words, do they just want to live off it, do they want to leave something behind for your heirs, do they want to spend a bunch traveling, etc.

If you're sure you could live on $25K in today's dollars a year, maybe $500-750K will be plenty. It all depends.

After I read this post, it reminded me of the Ben and Arthur story in Dave Ramsey's FPU. It shows that due to compound interest and an assumed rate of return, that saving early out-paces late savers who contribute more. You could build a similar table and find your tipping point.

Keep in mind that one of the benefits of contributing to a retirement account is avoiding income tax (either now, in the case of traditional IRAs/401ks, or later in the case of Roth IRAs/401ks). If you're in the 25% bracket, that's a huge incentive to keep saving in a retirement-advantaged account, EVEN IF you're past the "tipping point", since it's nearly impossible to get a 25% return like that anywhere else....

The "tipping point" isn't defined in the question. Suppose you have 10x your salary in the accounts. A 1.8% return in a given year will equal to the 18% of salary you are contributing to the accounts. A 7.2% return in that year will be 4x your own contributions. Suppose we use that as the tipping point. How long will it take to get there?

Using Excel, enter =NPER(0.06,-0.18,0,10). That's calculating the amount of time it takes for contributing 18% of salary every year to finally reach 10x when the account earns 6% a year. The result is 25 years. If your salary goes up, it's going to take longer, because your 18% contribution now won't be 18% of your increased salary. If you set a lower tipping point, not 10x of your increased salary, but 5x, it's going to take shorter.

The problem is that none of us have a crystal ball so we are unable to know what the future will bring. I believe that it's better to have "too much" rather than "not enough" when you start retirement.

We married in 1956, I'm 79 and my wife of 48 years is now 81. In our case Lady luck was good to us. Everything turned out unpredictably great after retiring in 1992. Thus we will be leaving a lot to our three children and a couple of grandchildren.

The events that turned out so well for me were:
1) Taking the time and trouble after retiring to learn all I could to become a wise investor.
2) Writing some financial software in 1993 that I was able to market quite successfully.
3) The dot.com bubble came at a perfect time and I had the knowledge and experience to take maximum advantage of it.
4) The Cold War was going on throughout my working life as an aerospace engineer so I had full employment, never lost a single day or was forced to relocate due to losing a job.
5) During the period 1963 to 1977 we bought two homes, a ski cabin and a beach condo. All appreciated greatly while we owned them. Now we just have our home and a condo that our son lives in.

Bottom Line
=========
Do your utmost to not make any bad financial decisions of which the two worst are frequently a bad marriage followed by an expensive divorce.

Not enough info in the question. Risk tolerance? Investment mis? Want to retire in 20 years (at 52?) 30? 40? Excellent to have a goal ($1.9 million, a 4%), and my thought is the goal today is definitely going to change. Inflation, taxation, lifestyle obligations (married, kids, single, parents? house or condo or apt, buy or rent? life events, unemployed? health?) all are going to be changing, and the 4% rule you are looking at is sketchy (just google it, Morningstar recalculates it today at 2.8%).

I've been calculating my 'number' since my middle teens (almost 40 years now) and it is amazing what seemed acceptable as the years went on. Highly recommend tracking not only your savings, but also your goals; you will be amazed 20 years from now.

Lastly, I don't think a normal person who makes a normal salary will ever hit a 'tipping point' where savings no longer has an impact. Even the last year of work provides 3 things: another year of salary, another year of savings, and another year of compounding. I would not stop saving until my goals were reached. You are doing a great thing, starting early, and wishing you continued success.

I've tried calculating when my investment gains will cover my annual expenses. We spend $30k a year so the investments need to throw off that much in dividends or gains for me to feel comfortable that my investments will cover expenses. However, there are no guarantees that dividends will continue.

Generally speaking, saving 18% for retirement means you'll be working until your mid to late 50s, anyway, unless you plan on significant lifestyle downsizing. So I don't think you need to worry about a tipping point until your savings rate increases significantly.

Here is a good blog piece on the math of retirement:

The short version is if you're saving 18%, it will take you 37-40 years of work before you can retire:

Contribute the maximum you can for 5 years and see where you are.You need to know how your money grows as to if you will have enough.

When I was 30 I had rolled over $50k to a IRA and contributed 10% to a 401k and each year I got a raise I raised it 1% until I had it up to 25% I did that for 20 years and now that I am 50 I max out each year currently at $23k.I also have contributed to a Roth IRA for 20 years and have maxed out my roth ira for the past 5 years. I am to a point that I am thinking I will have enough by the time I reach 60 but will not know for another 5 years.

The past 6 years has been the most difficult in the 30 years I have been working.

Matt:
I think the last few years have been very difficult for lots of people and the least fortunate fare the worst of all. Silicon Valley is home to many billionaires but when you exit a freeway there's usually a young healthy guy holding up a piece of cardboard with a sign asking for money. At Home Depot the other day I had just parked near the front, by the outdoor snack shack when a young, very scruffy, young guy rode up on his bike, went up to the window where the attendant casually handed him a small plastic bag. He then sat on the curb and started devouring the contents, which were crusts of bread. There are also homeless encampments along some of the creeks in San Jose, and often when you drive out of the Costco parking lot there will be a family with young kids, sitting on the sidewalk with signs requesting money. Some of the happenings these days are reminiscent of the stories about the Great Depression and Dust Bowl when people had to leave their farms in Oklahoma and some nearby states, pile into an old Jalopy and head Out West, just as John Steinbeck chronicled in some of his famous books.

To answer the main question, it is best to continue to pour money into retirement. If you are the type who has a lot of discipline, think about the tax savings and continue going. Why worry about a 'future tipping' point, esp. knowing that the Super Power status of the US is being lost to China / India / Someone-else. If that is the case, even if you define a tipping point, will your investment beyond the tipping point be forecastable at the past CAGRs?

Forecasts depend on your minimum CAGRs to come true, and I do NOT think that the assumption is really going to be valid, NO MATTER who says what.

Look at what Limey wrote......This is happening in all big cities including New York City, Toronto, Chicago, Houston, Atlanta and other places, and we are NOT talking Bums here. We are talking about healthy people that are out on the lookout for jobs, money etc.

I own rental real estate and I still get people losing their homes coming and looking for apartments. All of my apartments are full, and there are many very young people or much older folks. Lots of people are late in paying rent also.

All of the GDP 2%+ talk, the stats on 6.7% unemployment and the talk about so much 'progressiveness' in our country is masked under the reality out there of 30 hour week employees who have to have 2 jobs to survive and most of the job creation is the $8.25 to $15 per hour jobs.

I think there are two major issues with this question. #1, I find it ridiculous whenever anyone thinks they can project returns over the next 10-15 years (they guess a range like 7-9% instead of a more realistic range like 0% to 15%).

Secondly, if you ever do stop saving, then you're spending more, increasing SOL and thus requiring more in nest egg to maintain that SOL. Spending instead of saving hurts both sides of the retirement equation.

Simple answer to help you transition to what you want. As long as you're employed by a company willing to give you free money, keep contributing up to the 401K match. Then half way towards your goal of 15 years, at 7 years, begin investing an equal amount in Roth and after tax accounts. This way you will be covered on both ends of the tax spectrum.

I think the exact answer to this question is less important than the basic concept behind it-- namely that early savings make a lot more difference than late savings when it comes to retirement. This assumes that investment returns significantly outperform inflation, which while by no means guaranteed, it has been true over long time periods throughout our history so seems to be the best bet.

You can compare this by looking at an example, if average investment returns are 10% per annum and inflation is 3%, the difference of 7% implies doubling every decade if you apply the rule of 72. So every dollar invested at age 21 is worth 2^7 or 128x every dollar invested immediately before RMD time at age 70. In-between there isn't a "tipping point" where the value drops suddenly, it's a gradual power-law curve: age 28 = 64x, 35 = 32x, ..., 56 = 4x, 63 = 2x, 70 = 1x.

In my own case I went full blast retirement savings during my early years, then after about 20 years of work I noticed that if I stopped contributing immediately, my 401k+IRA balance extrapolates out to RMD payments at age 70 that are more than my current W2 income after adjusting for inflation. So I stopped adding to my IRA and am only contributing just enough to get my company match in my 401k. Granted mine was an abrupt change, but my "tipping point" was not due to a kink in the growth curve, it was because I suddenly realized that deferring taxes may not be a good idea if future income and tax rates are both going higher.

Old Limey was on target when he says none of us have a crystal ball. That is the problem. Many of the comments state that the formula to answer your question relies on numerous assumptions that may or may not pan out.

The bottom line is that there is not a good answer to your question when you are so far away from retirement. The scenario regarding what you will need to spend to maintain your desired lifestyle together with the tax, political, personal and inflation environment is simply unknown.

How long will you live?
Unknown.
What will your health be like at 60 years old ?
Unknown.
Will you have parents or children depending on you for income or health needs?
Unknown.
Will the stock market cooperate?
Unknown

I could build a scenario for you that looks great and one that leaves you homeless depending on your assumptions. And they are not crazy. Could inflation hit 7, 8 or 10%? Absolutely. Could the stock market tank like in Japan and be flat or downward for 10 years? Yup. Could interest rates stay low for another 5-10 years? Yes again. We just do not know. Anyone telling you they do know is fooling himself.

Inflation could be huge like it was in the late 70's and your savings may not buy anywhere near what you thought it would. Taxes could skyrocket and cut the net amount available for you to spend in half---or worse. The government could decide to means-test benefits like social security and Medicare and prohibit those with savings to partake.

Having too little is scary. Having too much will always be the better choice.

This is one of the more engaging discussions that I have seen in awhile.

A question for original poster, or any one else for that matter, when discussing your contribution to a 401K as a percentage of income does the 18% include the employer's contribution amount? For example if your employer contributes a 7% match, would that mean you are contributing 25% of your salary?

Just curious as I often read about contributing X% of your salary to a retirement account, but have wondered if that could be adjusted if receiving a generous match from an employer.

Agree with m19. There are just so many variables--not just the performance of your investment and the economy generally (enough by itself!), but your health, your family responsibilities, your lifespan...anyone who thinks they can confidently predict all those (largely unrelated) factors well into the future is nuts.

M19
I used some of the skills that I gained performing computer analyses of missile components to transition into performing analysis of stockmarket behavior after I retired. Getting an annual subscription to an analysis and charting service really paid off in my case when the dot.com bubble started forming. There are a great many analytical techniques available and it was a lot of work getting up to speed in recognizing when it was time to buy and then time to sell, even though your timing is never perfect.

The charting service was a great help in locating funds that owned many of the the big hi-tech movers.

The index that most closely followed the bubble was the Nasdaq 100 or NDX.

On 10/22/1999 my portfolio was $1,770,281, the NDX was 2,637.
On 3/15/2000 my portfolio was $3,021,835, the NDX was 4,130.

Both were showing very good gains. That's when the bubble burst and I got completely out over 4 trading days.

The NDX went on to bottom out on 11/30/2000 at 2,506.
My portfolio on 11/30/200 was $2,941,055.

As you can see, the Buy and Hold investors lost all of their gains whereas the market timers held on to most of theirs.

Market timing is not that difficult once you have learned how to recognize tops and bottoms however it does take a lot of experience and requires daily study of the charts. I am the first to admit however that I could have never found the time to do it while I was putting in long hours at work and often doing a lot of overtime.

Hi everyone -- thank you for your insight and feedback on my question. I do realize it was a bit vague, but I was hoping to get a sense of when I can "lay off" the contributions to my retirement plan and focus on other areas of my life, i.e., buying a home or having a child.

From what you guys are saying, it sounds like I should never totally quit contributing, even if I reach early goals. I'll likely decrease my contributions a bit, maybe down to 10 percent, but I should never stop altogether.

@Blake
Homes have turned out to be incredibly good investments where I live in Silicon Valley. You should never give up focusing on getting married, buying a home,and having children if that's something you really desire. They are the foundation of a long and happy life.

I started saving money when I was a teenager and got my first job which was delivering newspapers. The money I saved came in handy later on when I gave my girlfriend a nice engagement ring, even if it was secondhand. Later after we got married we decided to emigrate from England to Canada where I was offered a good job as a junior aircraft engineer. The company paid our boat fares but we still needed money to move into an apartment and a little later to put a downpayment on a used car. Thus "Saving Money" is a necessity that goes along with also having the bare essentials of a nice life. Later on when you settle down into a secure job it's often a good time to buy a home and start a family.

You should never stop saving since you have no idea what the future may have in store for you. I hope your life turns out even happier than mine but life is full of surprises, both good and bad, and money can often get you through some of the bad ones. In retrospect we could have bought a bigger and more expensive home, had much more expensive vacations, and been a lot more generous to our children, but we never had a crystal ball. It so happened that our investments did far better than we hoped but that's one of the things that can easily go either way. The same thing can be said about the health of you or a member of your immediate family. Having money can solve a lot of problems.